East Orange, N.J. â As a rising number of Americans sign up for unemployment benefits, many of the state-funded trusts that pay them are on the decline.

At least 12 of them are on the brink of insolvency. In 20 other states, the funds have lost value, even before the big job losses of the past two months.

While unemployed workers will get their benefits â federal law requires it â the trust fund woes are putting states into a peculiar squeeze. They're loath to raise taxes or cut services in a recession, so many are racking up new loans. That debt burden will affect residents for years to come.

"No one wants to raise taxes in the middle of this kind of recession. And nobody wants to cut benefits," says Maurice Emsellem, an Oakland-based policy analyst who focuses on unemployment insurance issues for the National Employment Law Project. "So the states are going to have to borrow ... and that's going to have a cost." The costs are already being rung up in some of America's biggest states. California's trust fell 42 percent in the year ended September, the latest period for which numbers are available, leaving it with enough to pay four months of estimated benefits. New York's trust had enough for two months of benefits; Indiana's, just one month. Michigan's is already bust. It has borrowed $550 million from the federal government to fill the hole.

The demand for benefits, meanwhile, is likely to soar.

Stamping his feet against the chill, Colin Hollinghead is waiting in line outside a New Jersey employment-assistance office in East Orange, one of the state's poorest towns. The 40-year-old father was laid off last month from a local auto-parts distributor. After a fruitless hour on hold this past Friday, he says he decided to come down to see if he could file for unemployment insurance in person.

"Money is real, real tight and it's the worst time of year,'' he says. "There's supposed to be an office to help you find a job in there, so I'll check with them ... but I'm not expecting anything."

The good news for Mr. Hollinghead is that the federal government extended unemployment benefits for seven more weeks in an emergency bill rushed through Congress at the end of last month. That follows an earlier extension of 13 weeks passed in June that now brings the total run of the benefit to 10 months and protects more than 1 million Americans whose checks would have otherwise stopped coming this holiday season.

The widening budget shortfalls have some states weighing tax increases, despite the recession. Michigan, one of the hardest hit states with unemployment above 9 percent, is already pushing up payroll taxes.

State budget problems are likely to worsen before they improve. Of the states that completed a survey from the National Conference of State Legislatures (NCSL) last month, 38 said they were expecting to be in the red for the year ending in September 2009 â a total budget gap of $32 billion. Worse, 26 states forecast more red ink â a cumulative $65 billion â for the following year.

"As bad as the current state fiscal situation is, it may pale in comparison to what looms ahead," the NCSL said. "As a rule, state finances lag the national economyâ¦ this means that the toughest years lie ahead."

One likely option: cutting state services
With the easiest options already tapped, states may have to cut services.

"Food stamps I'm not worried about â it's entirely federally funded," says Rebecca Blank, a senior fellow and economist at the Brookings Institution in Washington. "But I do worry about the healthcare programs and education. Medicaid is such a large part of the budget that it's easier to cut services."

Cutbacks in education could undermine an eventual recovery because that will mean fewer highly qualified workers, she adds, pointing to California's proposed $100 million cut for its state university system.

The state unemployment trusts are funded through the collection of payroll taxes and administered by the federal government under guidelines that require the money only be used to pay unemployment benefits, which average about $300 a week nationally. But the states still have considerable discretion over how much they pay into the system.

For instance, states are only obligated to tax the first $7,000 of a salary to fund their trust, says Mr. Emsellem of the National Employment Law Project. Increasingly, states have been sailing close to this minimum, under the assumption that the risks of a deep recession were outweighed by the benefits of encouraging industry. He estimates the average national "base" such taxes have been collected on has been $11,000.

"In the past 10 years in states like California, the employers were saying 'let's reduce taxes so we can extend payroll' and they got what they wanted,'' he says. "So even during the dot-com boom here during the '90s, we were hardly collecting more in revenue then we were in the previous decade. There's no big secret as to how we got here."

Indiana's troubles began about five years ago when labor unions and business clashed over a plan to cut payroll taxes, says state Sen. Luke Kenley (R). At the time, its unemployment trust was about $2 billion.

In the end, an actuary concluded that the system was overfunded beyond any foreseeable event, he says. That analysis convinced legislators not only to cut payroll taxes but also to increase benefits to those who were already unemployed. The trust started to deplete.

Then, unemployment worsened as oil prices surged, especially in places like Elkhart, the so-called "RV capital of the world," which saw demand collapse. The trust's funds fell 77 percent to $91 million in the past year.

"I was concerned at the time that we were kidding ourselves that we could increase benefits,'' Senator Kenley says.

Today, he anticipates the state will eventually raise payroll taxes again to fund the system, though the state's overall finances are sound, he adds. "We don't anticipate cutting services as much as we do 'spreading the pain' kind of ideas, like freezing wage schedules for all state employees."

States await Obama's recovery package
Only 38 percent of unemployed Americans receive benefits, Emsellem points out, so the problems with unemployment trust funds represent only a fraction of a growing need. The answer, he says, lies in more federal money. "What it all comes down to is the size of this whole recovery package that President-elect Obama and that Congress are putting together,'' he says.

Many states appear to agree. New Jersey's trust, despite a $260 million emergency loan from Washington five months ago, is about to borrow money again with just four months of money for benefits left.

"The scope of this may well have to be met at a federal level," says Kevin Smith, a spokesman for the New Jersey Department of Labor.

New Jersey, like Indiana, made a decision to deplete its fund in the 1990s, diverting $4.7 billion from it to other uses. New Jersey Gov. Jon Corzine, who says he put a stop to this practice when he took office in 2006, told the Star Ledger recently: "We have to pay that piper ... either by putting money into that system from some other place or we're going to have get help from the federal government."